Changes in the exchange rate have important implications for most economies — particularly those, like the UK, which are relatively open to international trade. Unfortunately, however, the determinants of the exchange rate are poorly understood and predicting its future value is notoriously difficult.
Having said that, there are some generally accepted empirical regularities which help us understand exchange rate behaviour, at least in the long run. One of these is the idea of purchasing power parity (PPP), which, at its most basic, states that the exchange rate should reflect differences in the cost of purchasing similar baskets of goods in different countries.
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